Quick! What is your marginal tax rate?
If you answered “I don’t know”, then welcome to the club! Pull up a chair and sit down for a spell. Most of us do not know what our marginal tax rate is… which is really too bad. It’s one of the more useful pieces of information to know when it comes to making informed decisions about our personal finances.
The technical definition of a marginal tax rate is that it is the rate of tax that is paid on an additional dollar of income.
…Um… what does that mean?
Good question, Gentle Reader, very good question.
Federal Tax Rates
Before you can understand a marginal tax rate as it applies to your personal income, you need to know the federal tax rates. Here’s a handy little chart I found online courtesy of the good folks at the Canada Revenue Agency.
| Federal Tax Rates in Canada |
| 15% on the first $48,535 of taxable income |
| 20.5% on the portion of taxable income over $48,535 up to $97,069 |
| 26% on the portion of taxable income over $97,069 up to $150,473 |
| 29% on the portion of taxable income over $150,473 up to $214,368 |
| 33% of taxable income over $214,368 |
Let’s walk through an example together.
*** And we’ll ignore your marginal provincial taxes for now. (What? You thought the provinces didn’t want a slice of your income too?) In real life, you won’t ignore the addition of marginal provincial tax rates on your annual income tax bill. You’ll pay the provincial marginal taxes on top of your federal ones since you’re required to do so by law.
How Marginal Tax Rates Work
Jamie earns $47,000 and pays 15% in federal taxes, which works out to $7050 (= $47,000 x 15%). If Jamie earns another $1, his marginal tax rate is 15% because he stayed in the same tax bracket of 15%. Jamie’s additional $1 of income did not take him over the threshold amount of $48,535.
On the other hand, if Jamie’s side hustle earns him $5,000 in the year, then his marginal tax rate goes up to 20.5% on the amount of income that exceeds $48,535. Between $0 and $48,535, his tax rate is 15%. As soon as he earns his next $1, putting him at $48,536, he moves into the next tax bracket. His marginal tax rate is now 20.5% because that’s the rate of tax he pays on his next dollar of income.
In this case, Jamie’s income for the year is $52,000 (= $47,000 + $5000). Jamie would pay 15% on $48,535 (= $7,280.25). Then he would pay a further 20.5% on $3,465 (= $710.33). In other words, Jamie pays a higher amount of taxes on the dollars earned above the 15% tax threshold of $48,535. In this case, the amount of $3,465 is the difference between his income of $52,000 and the 15% tax threshold of $48,535.
At $52,000, Jamie’s marginal tax rate is 20.5%. More importantly, his marginal tax rate on every dollar earned beyond the first $48,535 remains at this tax rate until he hits $97,069. He owes $7,280.25 + $710.33 = $7,990.58 in federal taxes on his income of $52,000.
Imagine Jamie doubles his income to $104,000 per year…
Good for you, Jamie!
So how much federal tax does Jamie owe on $102,000?
A quick check of our handy-dandy little chart tells us that Jamie’s marginal tax rate is now 26%. Why? Because Jamie has earned more than $97,069, which is tippy-top of the second lowest tax bracket.
Further, we know that he only has to pay 26% on the dollars over and above $97,069.
So let’s get to calculating.
We know Jamie owes 15% on the first $48,535 = $7,280.25.
His next $48,534 will be taxed at 20.5%, because $97,069 – $48,535 = $48,534. So Jamie will pay $9,949.47 (= $48,534 x 20.5%).
Finally, he will pay 26% on any dollar of income over $97,069. In this case, Jamie earned $4,931 beyond $97,069 to get to his income of $102,000. The amount of $4,931 is taxed at his marginal tax rate of 26%. Jamie will owe $1,282.06 on this portion of his income.
Jamie’s total federal tax owing is $7,280.25 + $$9,949.47 + $1,282.06 = $18,511.78.
Tax refunds, anyone?
Here comes the part where things get a little exciting! The more taxes you pay on your income, the more taxes you can get back via contributions to your Registered Retirement Savings Plan. The RRSP is a great tool for saving for your retirement.
Contributions to an RRSP lead to tax refunds, which means the tax paid on that earned income is returned to the person making the contribution. The more tax you pay, the bigger your refund. And why is this so? Because a higher marginal tax rate is used to calculate your tax refund. Sweet!
The 2021 TFSA contribution limit is $6,000. TFSA contributions do not generate tax refunds. Money goes in and it grows tax-free until withdrawn. And those withdrawals are also tax-free. The TFSA is also a great way to save for retirement.
However, contributions to a TFSA are just contributions where the taxes have already been paid on the income earned. This is why contributions to TFSAs are said to be made with after-tax dollars.
Steak…meet sizzle!
Let’s say Leslie earns $250,000. According to our handy-dandy little chart, she’s paying 31% in federal taxes. Ouch!
And then there’s Alex, who earns $48,000. The chart tells us that he’s paying 15% in federal taxes.
Both of them are in a position to contribute $6,000 to their retirement. They have a choice of contributing to their Tax Free Savings Account or to their Registered Retirement Savings Plan. (In an ideal world, they would contribute to both but sometimes that’s not possible.)
Leslie and Alex both decide to contribute to their RRSPs. They like getting taxes back from their government! And both of them have realized that their tax refunds can be used to contribute to their TFSAs. Two birds, one stone – beautiful!
Leslie contributes $6,000 to her RRSP. Her marginal tax rate is 31%. This means that her RRSP contributions results in a tax refund of $1,860 (= $6,000 x 31%). She promptly puts that into her TFSA. Leslie’s $6,000 RRSP contribution has resulted in her ability to set aside $7,860 for her retirement.
Alex contributes $6,000 to his RRSP. Since his marginal tax rate is 15%, his contribution nets a tax refund of $900 (= $6,000 x 15%). He contributes that $900 to his TFSA without delay. Since he’s in a lower tax bracket, he paid less taxes in the first place. Still, he’s managed to save $6,900 for his retirement – not shabby at all!
The morale of this little tale is this. You must know your marginal tax rate so that you can make wiser financial decisions. Had Leslie and Alex simply contributed $6,000 to their TFSAs, they wouldn’t have received tax refunds. Their monies still would have grown tax-free but neither of them would have benefitted from the added little boost of also being able to invest their tax refunds.
Understanding how marginal tax rates work is just another arrow in your personal finance quiver. Knowledge is power.
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Weekly Tip: Never carry a balance on your credit card. It’s a financially disastrous move. Even if the interest paid it small, it plants the seed in your brain that credit card balances are okay. And the most certainly are not!